NAFTA

The Atlantic Monthly

December 1992

What Price Economic Growth?

To judge by the example of Canada, which began an experiment in free trade with the United States in 1989, the proposed U.S. free-trade agreement with Mexico is a threat to the social comity on which prosperity depends

by Jonathan Schlefer

“Free trade” is shorthand for both an ideology and a theory of the way things are supposed to work out for the best between trading partners. If the United States goes ahead with the proposed North American Free Trade Agreement (NAFTA) with Mexico and Canada, it will be betting a great deal on that theory. Proponents of the agreement argue that it will bring economic growth to all three countries. Opponents say that it will erode support for social-welfare programs and aggravate inequality, especially in the United States, where the gap between rich and poor has been widening ominously in recent years. Both sides could be right. I will argue that the agreement confronts us with the question posed in my title.

Before elaborating that argument, I want briefly to review the history of the free-trade agreement. The current pursuit of this grand abstract idea has roots in the domestic politics of our North American neighbors, Mexico and Canada. Indeed, when one considers it in the context of its gestation, there is an asymmetry about NAFTA–as if our neighbors figured out that to get us to help them politically, all they had to do was invoke the right Republican ideological shibboleths. In that sense NAFTA is a belated monument to Reaganism.

It was not the United States but Canada that proposed the free-trade agreement that has been in effect between the two nations since 1989, and it was Mexico that pressed for the negotiations that may well lead to the North American Free Trade Agreement among all three countries. Despite the vast differences between Canada and Mexico, their governments’ motivations were remarkably similar–and illuminating about hoped-for changes in the continent’s economy.

In Canada, the Liberal Pierre Trudeau, as Prime Minister, had followed a century-long tradition of what was seen as national industrial policy. The government protected many industries with tariffs three times as high as those in the United States, approved only foreign investment that it deemed of “significant benefit” to Canada, and often imposed requirements on foreign firms such as that a given proportion of purchases were to be made locally and that a given percentage of production was to be exported. The Conservative Prime Minister Brian Mulroney came to power in 1984 convinced that Canada, with a manufacturing productivity frequently reckoned to be 25 percent lower than that of the United States, needed a dose of the free market. The Macdonald Royal Commission, convened to examine the economy, predictably concluded in 1985 that “we Canadians must significantly increase our reliance on market forces.” What was innovative was the means it suggested: “free trade is the main instrument” the government should use to achieve this “fundamental change in the relationship of the state to the market.” Some weeks later Mulroney proposed the free-trade agreement to President Ronald Reagan. Gilbert Winham, the research coordinator for the commission, said, “In terms of its more profound interests, what Canada wants from the bilateral negotiation, it could achieve unilaterally.” The FTA not only is eliminating tariffs over ten years but has codified much of Mulroney’s deregulation–for example, precluding a return to investment policies like those of the Trudeau government.

Mexico’s economic history makes the Trudeau government look like the Eisenhower Administration. As late as the mid-1980s Mexico maintained tariffs of up to 100 percent, flat prohibitions on foreign investment in areas from basic chemicals to stock brokerage, intrusive rules for approved foreign firms, and state ownership of the oil company, banking, and many other enterprises. The economy grew more than six percent a year for decades–twice the U.S. rate–but in the late 1970s Mexico borrowed heavily just before interest rates soared, counted on oil revenues just before prices dropped, and wound up with its famous debt. Partly as a condition for receiving temporary loans from the International Monetary Fund, but finally because they, too, favored a dose of the free market, Presidents Miguel de la Madrid and Carlos Salinas de Gortari brought to an end the history of state economic intervention. After changing the rules in 1989 so as to welcome foreign investment, Salinas waited for the influx. But, as was made clear in an October, 1990, study by the U.S. International Trade Commission, investors feared that what Salinas did, his successors could undo. Like Mulroney, then, Salinas proposed a free-trade agreement with the United States to secure domestic deregulation through an international treaty. Canada subsequently joined the negotiations, so that NAFTA will apply to the whole continent north of Belize and Guatemala.

The Motives Behind NAFTA

The Reagan and Bush administrations agreed to trade negotiations not only to help like-minded foreign governments but also for their own reasons. Global talks under the aegis of the General Agreement on Tariffs and Trade remained stalled through the 1980s. GATT has done one thing well–reducing tariffs on manufactured goods among advanced nations–and seems unable to do more. It has done little to facilitate foreign investment or control nationalist policies in countries ranging from Japan to Trudeau’s Canada, and it has not paved the way for firms to provide services abroad such as banking and data processing. The Reagan and Bush Administrations concluded that the United States needs progress in these areas to exploit its competitive strengths. With GATT stalled and trade blocs emerging in Europe and East Asia, the U.S. response was to try to develop a North American bloc. In a 1988 article about the free-trade agreement with Canada, James Baker, then Secretary of the Treasury, wrote, “Other nations are forced to recognize that the United States will devise ways to expand trade–with or without them.” In the article Baker used the phrase “to expand trade” interchangeably with “to open markets.” He wanted the terms of the treaty to reflect the same free-market policies that Canada sought.

NAFTA entails a similar bargain. It will both promote the free flow of goods by eliminating tariffs over five to ten years (fifteen for a few sensitive items) and establish rules to foster the flow of investment across borders, and it seeks broadly to increase North American reliance on market forces. All three governments, along with most economists and many business groups, share a conviction that this will strengthen the North American economies, largely by making manufacturing, financial firms, and some other services more efficient. Investors will be able to locate enterprises wherever they can operate most effectively–for example, developing advanced software in the United States and producing personal computers with less expensive labor in Mexico. Production can be planned on a broader scale, for the entire North American market, rather than in the piecemeal fashion of today, for particular countries with the hope of export. Products will become both cheaper for North American consumers and more competitive in world markets, according to Rudiger Dornbusch, of MIT, and other economists. These economists foresee few drawbacks to NAFTA.

The question is whether they are right. NAFTA is an experiment in opening the economies of industrialized nations to a major Third World country. Japan has no such agreement with its East Asian trading partners, and although the European Community admitted Spain, Portugal, and Greece into its membership, they are not comparable to Mexico. Spain has a per capita income close to half that of the United States, while Mexico’s is a tenth as high. Portugal and Greece are poorer than Spain but still have per capita incomes twice Mexico’s, and they contain only six percent of the total population of the EC; Mexico contains almost a quarter of North America’s population. The EC is bringing poorer member countries up to Community standards with billions of dollars of development assistance and the enforcement of common environmental and workplace regulations. The EC economic and political union, if it occurs, will make policies on matters from unemployment assistance to maternity leave at least as consistent as are those of, say, Massachusetts and Alabama today. In contrast, NAFTA proposes that the United States and Canada take Mexico as is, while Mexico pays back a debt of close to $75 billion–a kind of Marshall Plan in reverse. The treaty specifically allows each nation to establish its own environmental and workplace regulations. It is an experiment tried in economics texts but never before in history.

Consider Canada

The Canadian debate over the 1989 free-trade agreement is useful to consider: it set the tone for current NAFTA disputes, and the few years since the agreement was adopted tell something about its effects, and thus what NAFTA’s could be. The main issue in the 1988 Canadian elections, the agreement was supported by the Conservatives but opposed by the Liberals and the New Democratic Party–along with the Canadian Labor Congress, the Canadian Teachers Federation, the Canadian Nurses Federation, the Conference of Catholic Bishops, women’s groups, anti-poverty organizations, environmental groups, and, as Ernie Lightman and Allan Irving, professors of social work at the University of Toronto, put it, “virtually every non-business interest group in the country.” In the end the New Democratic Party and the Liberals split the opposition vote, and the Conservatives, with a plurality of 42 percent, won a majority in the House of Commons. The agreement was ratified, but Canadians, particularly lower-income Canadians, have remained broadly opposed to it in polls.

The concerns of Canadian critics center on erosion of the welfare state, which is much more generous in Canada than in the United States. For example, in Canada both health care and Old Age Security are universal–eligibility for the latter, unlike U.S. Social Security, is based not on work history but on age alone. The differences between Canadian and U.S. unemployment insurance are staggering. In 1988 seventy percent of unemployed Canadians received insurance covering 60 percent of their wages, while 32 percent of Americans received benefits covering 35 percent of their wages. In other words, nearly 70 percent in the United States got nothing. In both countries unions push for broad social programs (which reduce unemployed workers’ incentive to break strikes), but Canadian unions represent 36 percent of employed workers (outside agriculture), while U.S. unions represent 18 percent. The whole attitude toward unions is different. Canada Year Book 1992, a more colorful if less figure-packed counterpart to the Statistical Abstract of the United States, features in its chapter on employment a photo of a miners’ strike and a chart on “Unions With Largest Membership.”

Canadian critics of the free-trade agreement argued that it would prompt firms to desert the country for the United States, particularly for the South, where unions are weak. The firms could thus lower their wage costs and taxes, and ship products duty-free back to Canada. The result would be Canadian job losses, pay cuts, and pressure to curtail social programs paid for by taxes. Employment loss in manufacturing, a sector that accounts for a large portion of trade with the United States, was a particular concern. Polarization between rich and poor, which has become worse in Canada (though it has not yet reached U.S. proportions), would be aggravated as middle-income wages eroded.

Mulroney responded that by strengthening the economy, the agreement would allow Canada to improve welfare programs, and he rashly promised that it would create “250,000 new jobs for young Canadians over and above current predictions.” On a more sober note, J. David Richardson, a professor of economics at the University of Wisconsin and a consultant to the Economic Council of Canada, surveyed the various studies projecting the agreement’s effects and singled out as “worst-case limits” the loss of a “minuscule 0.2 percent” of Canadian manufacturing employment. Academic economists and the staff of the Ministry of Finance looked forward to the invigorating effects of freer markets and trade and to the prospect of 250 million U.S. consumers who would be able to buy tariff-free Canadian products.

It is hard to apportion blame between the agreement and the recession (yet another candidate is the monetarism of the Bank of Canada, Ottawa’s Federal Reserve), but after three and a half years, more than 15 percent of manufacturing jobs are gone. The headline on the April, 1992, Canadian Economic Observer, a government compilation, says, “More cutbacks in manufacturing push unemployment above 11 percent.” The most recent figures put unemployment at 11.4 percent. The Canadian Manufacturers Association found that half the members it queried had examined the costs of operating in the United States, and of that half, three quarters had concluded that doing so would be cheaper. The press has been replete with stories of firms moving south for just that reason. The Ministry of Labor in Ontario, a major manufacturing province, found that more than half the layoffs are due to plant closings, so the production is gone for good, whereas less than a quarter of job losses in the 1982 recession had this permanent character. A senior adviser to the Finance Minister, speaking anonymously to the newsweekly Maclean’s, concurred: ‘The problem now is that we are losing manufacturing activity itself to the United States.” This is a far cry from even the direst projections of economists.

Now they say that they were looking at the long run, that four years is too little time to judge the results, and that any manufacturing losses have been caused by the recession. That does not explain why the losses are more serious now than in 1982, or why they are so much worse in Canada than in the United States. While the volume of U.S. manufacturing actually rose 1.6 percent from 1988 to 1991, that of Canadian manufacturing fell 11.4 percent. The explanation for the faulty predictions of the Canadian free-trade models may lie in their assumptions. Economics treats unemployment as a short-run effect of recessions, and according to James Stanford, of the New School for Social Research, the Canadian free-trade models assumed full employment and a fixed volume of investment in both countries. Capital would move to more-productive activities within Canada, but corporations would not widely shut factories and import goods from lower-wage U.S. plants. In short, the assumptions built into the models ignored critics’ major concerns, and thus, not surprisingly, the models’ conclusions suggested that the concerns were groundless. Stanford notes that the same assumptions are built into most models that predict favorable outcomes for NAFTA.

After the agreement was signed, business leaders began raising a clamor in the press that high taxes as well as labor costs were inhibiting their competitiveness. Mickey Cohen, a former deputy finance minister, told the Toronto Financial Times that Canada faced “greater pressure to harmonize” social programs with the United States: “If we’re going to compete, we have to look more like the guys we’re competing with.” Sure enough, there has been pressure on Canadian social programs. The most significant was on unemployment insurance, which the Mulroney government weakened in November of 1990, so that workers had to be employed longer to be eligible and received benefits for an average of thirteen weeks less. Now the portion of the unemployed who are covered has dropped from 70 percent to 58 percent. Those no longer supported by unemployment insurance get welfare from provinces and local municipalities. But these levels of government are receiving a smaller share of revenue transfers from Ottawa. Some social programs have been trimmed. For example, in 1991 federal payments to Newfoundland, a poor province, were cut by $180 million. The town of Port Aux Basques, in turn, lost $1 million from its hospital budget and laid off a third of the staff. Threats to social programs would have occurred without the free-trade agreement–federal-government budget deficits were a problem before the treaty–and in time those Canadian manufacturers that survive will no doubt improve their productivity. But events have at least partly borne out what the agreement’s critics said.

The Mexican Portent

Unions in the United States are well aware of the Canadian experience as they look south toward a country with far lower wages than their own. Last year William J. Cunningham, of the AFL-CIO, told the House Committee on the Budget that 50 to 70 percent of U.S. workers will lose ground under NAFTA. “Farther up the economic ladder, the affluent minority would certainly benefit….Multinational corporations would hit the jackpot” by paying Mexican workers “a small fraction of average U.S. wages” and supplying no workmen’s compensation, unemployment insurance, health insurance, or “other essentials of civilized life.” The environmental movement has been vocal, particularly about the maquiladora plants set up in Mexico to export to the United States. Some managers privately admit that their plants moved from the United States to evade enforcement of health and environmental laws. A statement in The Wall Street Journal that the maquilas‘ “very success is helping turn much of the border region into a sinkhole of abysmal living conditions and environmental degradation” has achieved celebrity. Friends of the Earth and other environmental groups say that NAFTA will bring more of the same.

Citizens’ groups in Mexico have not similarly debated NAFTA. The Partido Revolucionario Institutional, a party that actually does embrace both revolutionary and institutional elements, has held power since the 1930s, and once the President of Mexico sets a priority, opposition becomes a serious political matter. In the case of NAFTA the opposition has come mainly from a left-of-center political coalition headed by Cuauhtemoc Cardenas. He almost defeated Salinas in the 1988 presidential election. (He may actually have won: the government prevented public scrutiny of almost half the ballots.) Cardenas echoes his northern counterparts on NAFTA: “The exploitation of cheap labor” and “lax environmental protection” should not be “the premises upon which Mexico establishes links with the U.S., Canada, and the world economy.” NAFTA will create jobs, but without political reform might not do much for wages, working conditions, or the environment. Despite an increase in foreign investment, manufacturing wages fell 25 percent in the 1980s. Collective action is risky, to put it mildly. If the leaders of a union local call a strike, they may well be ousted from their jobs, often with the cooperation of the main union federation, which is part of the PRI. And violence against organizers is not unusual.

Thus North American opposition to NAFTA (which in Canada has taken up where opposition to the U.S.-Canadian agreement left off) is centrally concerned that the treaty will free investors to roam in search of the lowest wages, weakest environmental and workplace regulations, and most-minimal taxes and other public contributions. NAFTA will, in short, free investors from political sovereignty. Governments, which at least claim to treat all people equally and to represent some common interest, will lose ground to the market, a process that, according to Maude Barlow, the chair of the Council of Canadians, an organization opposed to the agreement, means “weakest to the wall, survival of the fittest.” Advocates of NAFTA do not entirely disagree but want more reliance on market forces and less on government nonetheless. “The bulk of government policies [are] motivated not by the desire to increase overall public welfare,” writes Herbert G. Grubel, an economist at Simon Fraser University, in British Columbia. “Rather they are designed to provide benefits for special interest groups in order to secure their financial and voting support.” If so, then perhaps the free market is a solution, and NAFTA is a step in that direction. Grubel applauds the way “increased international competition constrains the power of special interest groups.”

Growth By Inequality

A curious thing is that the more carefully one considers the NAFTA debate, the less it seems that advocates and critics actually contradict each other. Those who favor the treaty say it will boost economic growth by strengthening the competitiveness of North American manufacturing and other firms in global markets. Opponents say it will threaten moderate-income wages (at least in Canada and the United States), erode social programs, and weaken the economic sovereignty of the state. It is perfectly conceivable that both predictions will be borne out. In the United States in the 1980s, according to government statistics, the growth of manufacturing productivity and of the economy as a whole was higher than it had been in the 1970s and was almost at the level of the 1950s and 1960s–yet 44 to 70 percent of the increase in income went to the richest one percent of all families (the variation depends on whether one adjusts for the declining size of families), and lower-middle-income families and the poor lost ground. Critics are saying that NAFTA will promote more of the same.

This lack of direct disagreement between advocates and critics of NAFTA reflects standard economic theory, which predicts both “gains from trade,” meaning higher total income and more efficient production, and “trade adjustments,” including job losses and salary cuts for some. “Trade adjustments” sounds pleasantly minor and temporary, but though economists do not like to say so out loud, their texts explicitly confirm that losses can be large and permanent. In one report on NAFTA, the U.S. International Trade Commission concluded that “U.S. skilled workers and owners of capital services would benefit more from lower prices and thus enjoy increased real income” (these are gains from trade), but that “unskilled workers in the United States would suffer a slight decline in real income” (these are adjustments). The ITC did not say what portion of U.S. workers it considers unskilled, but according to Jeff Faux, of the Economic Policy Institute, the ITC’s model, based on the 1980 census, classifies 26 million American workers as skilled and 70 million as unskilled. Moreover, the ITC’s assessment of a “slight decline” depends on timing. Standard economic theory says that wages in a given line of work converge totally and forever. (An adjustment for productivity remains: if productivity is 25 percent higher in one country, that country’s income is 25 percent higher. But Mexico has, for example, auto and electronics export plants with productivity at U.S. levels.) Certainly it will take a long time for capital to move and for the changes in wage levels to occur. How long depends on judgments of investors which no one can quantify. But it could be a long way down for many Canadian and U.S. workers. There could also be substantial improvement for workers in Mexico, if political suppression of wage demands abates.

Economics leaves the debate at this impasse–a prediction of “gains” from overall growth but “adjustments” potentially harming large groups–because its most basic premises have to do only with gross income. In economic equations a dollar is a dollar, as long as it is adjusted for inflation, whether it accrues to a homeless person or a millionaire. The discipline has no means of comparing one person’s additional “utility” from a dollar with another’s. It can only be sure that more national income yields greater utility. Economists prefer a higher national income because, in principle, governments can redistribute it to achieve equity and leave everyone better off. Many economists advocate such redistribution, but they are the first to admit that this is a “normative” judgment quite separate from the discipline of economics itself. If NAFTA raises national income (as advocates promise) but distributes it in an inequitable fashion that governments will not remedy (as opponents believe), then the treaty poses a trade-off that economics, by its own assumptions, cannot address.

The Conditions of Well-Being

If we accept this framework, the question becomes one of means and ends. Should the end be to promote the fastest possible growth, or is some adequate level of economic activity a means to broad material well-being? In both the United States and Canada, as mentioned, the 1980s saw rapid economic growth that went predominantly to the wealthy. The result in the United States has been a widespread sense of discontent, made vivid in the specter of homeless people and the worst urban riot in decades. The result in Canada has been similar though more moderate. Certainly the end should be broad material well-being for society, and though at other times and in other places the means would be different, the United States and Canada now need greater equity. If faster growth must be sacrificed to achieve that, so be it. The matter is not so clear-cut for Mexico. It needs both substantial economic growth, which could come from investments brought by NAFTA, and a more equitable distribution of income, which requires political reform.

The framework of the question posed this way remains limited, however. Textbook economics has been so thoroughly melded into what we accept as common sense that even critics of NAFTA rarely dispute the claim that freer trade will promote economic growth. A typical example is the labor leader William Cunningham’s statement that “the affluent minority would certainly benefit” and “multinational corporations would hit the jackpot.” In the end, will they really? The reasoning that leads to this conclusion is based on a conception of society as a set of individuals each maximizing his or her utility. Any divergence from that situation is, in the terminology of economics, an “imperfection.” Simply put, the argument is that the less individuals are hindered from maximizing their utility, the more they will do just that, and the greater will be the sum of their utility, which is the gross national product.

Suppose society is actually more than a collection of individuals. It may be that some measure of equity is in fact required for the cooperation on which long-term economic growth depends. The late Chilean economist Fernando Fajnzylber studied this relationship. (No wonder he was interested: his country both grew slowly and had an inequitable income distribution, even by Latin American standards.) In a comparison of Japan, West Germany, and the United States, Fajnzylber found that since the mid-1960s income distribution has been most equitable in Japan, second most in West Germany, and least in the United States. Japan grew the fastest, Germany the second fastest, and the United States the slowest. He noted that in level of savings as well as growth, Japan was first, Germany second, and the United States last. And by various measures (civilian research and development as a percentage of national income, productivity growth in manufacturing, and others) Japanese manufacturing was the most competitive, German the second most, and the United States’ least. When economic leaders take too great a share of production and contribute too little to society, they lack the authority needed to guide patient, long-term growth.

That is a problem in the United States, Canada, and Mexico, and one that NAFTA will only aggravate. As investment moves south, it will wind up in Mexico, undoubtedly providing some benefits there. Yet looking at long-term prospects, even Mexico might not do particularly well hitching itself to a North American trading bloc that is more inequitable and less farsighted than either Europe or East Asia. The culprit is not wider trade but the way NAFTA will achieve it, by allowing investors to desert countries with better wages, stronger environmental and workplace regulations, and higher taxes. The EC, to which proponents often compare NAFTA, is increasing trade through a diametrically opposite project: the strengthening of common economic sovereignty, not the undermining of what exists. That is the sort of cohesive effort North America needs.